Introduction to Weather Derivatives By Anjelina Belakovskaia Weather Derivatives Trader Head of the Weather Desk at Williams Co. Copyright 2002 © Anjelina.

Introduction to Weather Derivatives

By Anjelina Belakovskaia

Weather Derivatives Trader

Head of the Weather Desk at Williams Co.

Copyright 2002 © Anjelina Belakovskaia

• Q: What are Weather Derivatives?• A: Options to buy or sell sun, rain,

snow, wind, etc… as well as swaps (exchange rights) on the above.

+ =


Somewhere RAIN creates flood. Somewhere DROUGHT lasts for months.

Some areas are HOT. Some areas are COLD.


Weather Derivatives are used when:• Company’s revenue is sensitive to the

temperature, rainfall, snowfall, etc… • Weather events are non-catastrophic.• Goal is to reduce risk due to weather exposure

and decrease volatility of return.• Credit exposure has to be diversified.

Also as investment strategies:• To diversify investment portfolio.• To capture inefficiency in the weather market.


WHO BENEFITS? Agriculture (early frost – yield, hot summer – livestock).

Construction (work interruption, damage to materials, project risk).

Energy (mild winter – less revenue, hot summer – extreme prices).

Entertainment (no snow – ski resorts, cold and rainy – Amusement parks).

Financial Institutions (uncorrelated to stock market).

Food Industry (mild summer – soft drinks and ice cream).


http://wrma.cyberserv.com/library/public/file161.pdf

WHO BENEFITS? Heath (pollen - allergies, heavy rains - viruses).

Insurance and Reinsurance (hedging some risk).

Municipality (heavy snowfalls – budget crisis).

Retail (cool summer – T-shirts, mild winter – fur coats).

Sport (football, baseball).

Transportation (trucks, trains, barges, airplanes).

Travel (canceled trips, less demand).


Trading Instruments and Measure:

• Calls• Puts• Swaps• Digital options• Strangles,

Collars• Baskets• Structures

• CDD – cooling degree days

• HDD – heating degree days

• VDD – variable degree days

• TMAX – max. temperature

• TMIN – min. temperature

• Rainfall – inches of rain

• Snowfall – inches of snow


Weather Calculations:

• CDD = MAX ( Temp – 65, 0 )• HDD = MAX ( 65 – Temp, 0 )• Temp = Average daily temperature

= ( TMAX + TMIN ) / 2• 65 => Base temperature (chosen)• VDD => Base temperature is different or

=> TMAX, TMIN is used instead of AVG or

=> SUM ( CDD & HDD )


Daily and Cumulative CDDs

0

20

40

60

80

100

120

1 2 3 4 5 6 7 8 9 10

Days

CD

Ds

CDD

Cumulative CDDs


Weather Market:

• OTC, 5-6 brokers.• ICE, CME, LIFFE.• Locations: Airports (mainly).• Seasons: May-Sep, Nov-Mar, monthly,

weekly, multi-year.• Size: $1-2 MM Notional (Cap).

$ 5,000 per DD.


Pricing Weather Contracts:

• 10 YR Mean.• STD.

• Swap => around 10 YR Mean.• Options => about 1/3 STD from 10 YR

Mean.

• Time Series and Distribution Models.


Electricity Load as a function of Temperature

Electricity Load increases with temperature primarily because of the use of air-conditioning. The increase in electricity load because of falling temperatures is smaller because natural gas is used for heating alongside electricity.

1000

11000

21000

31000

41000

51000

61000

0.00 20.00 40.00 60.00 80.00 100.00 120.00

Temperature

Load

PJM Load vs. Temperature

T > 90o FT < 32o F


Electricity Prices as a function of Temperature

0.00

200.00

400.00

600.00

800.00

1000.00

1200.00

0.00 20.00 40.00 60.00 80.00 100.00 120.00

Temperature

Price

PJM Price vs. Temp

Electricity Prices increase dramatically as temperature rises beyond 90 degrees Fahrenheit because of supply side constraints. A corresponding increase in electricity prices is not visible when temperature falls to freezing and below.

T < 32o F T > 90o F

Electricity Price Spikes


Trade 1: Long power + Short CDD Calls

TRADE OUTCOMES:

Very Hot Summer

Significant gain on long electricity position due to convexity of power prices with respect to temperature. Linear loss on short CDD Options capped at $ 1 million. Net outcome is a very positive pay-off.

TRADE A: Buy July power, when temperature is expected to be above 90o F and price spikes are likely.

TRADE B: Sell Out-of-the-Money CDD calls with a cap of $ 1 million. Collect $ 300,000 premium.

Mild SummerLoss on long electricity position is partially off-set by the weather option premium. Electricity prices do not fall as quickly.


Trade 2: Long gas + Short Heating Degree Day weather options

TRADE OUTCOMES:

Very cold winter

Significant gain on long natural gas position due to spikes in gas prices when temperature falls. Linear loss on short HDD Options capped at $ 1 million. Net

outcome is a very positive pay-off.

Mild winter

Loss on natural gas position is partially off-set by the weather option premium.

This trade is similar to the previous trade.

TRADE A: Long natural gas contracts for settlement in Dec, Jan or Feb when temperature is expected to be below 40o F and price spikes are likely in the natural gas markets.

TRADE B: Sell Out-of-the-Money HDD calls with a strike of 1200 and a cap of $ 1 million, when 10-year average of Dec-Feb HDDs is 1100. Collect $ 300,000 premium.


History:

• 1996 – 1997: Aquila, Koch & Enron –

1st weather-indexed commodity transaction.

• 1999: CME.• 2001: ICE, LIFFE.• 50 % - Energy.• 25 % - Insurance, Reinsurance.• 25 % - Other.


WRMA Survey:

0

1000

2000

3000

4000

5000

1998 1999 2000 2001

Number of Contracts, 1998-2001

Winter

Summer

0

1000

2000

3000

4000

5000

1998 1999 2000 2001

Notional Value of Contracts (in millions), 1998-2001

Winter

Summer

1,836

2,959

2,517

4,306


WRMA Survey:

Number of Contracts, 1998-2001

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1998 1999 2000 2001

Other

Europe

Asia

North AmericaSouthNorth AmericaEastNorth AmericaMidwestNorth AmericaWest

Notional Value (in millions), 1998-2001

0500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

1998 1999 2000 2001

Other

Europe

Asia

North AmericaSouthNorth AmericaEastNorth AmericaMidwestNorth AmericaWest


2001 – 2002 Energy Crisis:

• “post-Enron” era • Energy traders are replaced by Banks, Hedge

Funds, Reinsurance• Broader variety of sectors: Agriculture,

Construction, Entertainment, Sport, Travel and more…

• Geographical expansion to Asia, Europe & Australia.


New weather markets:

• Storms, Hurricanes, Tornados• Droughts• Floods• Food production• Hydroelectric production• Wind farms• and more…


New weather products:

Many fancy exotic solutions:

• “Refund for Rainy Days during Holidays” http://www.wrma.org/pdf/Medienmitteilung%20-%20CelsiusPro%20and%20AGA%20Collaboration_EN.pdf

• WindLock – Wind Power Variability Risk Hedging instrument

http://www.wrma.org/pdf/3TIER-Galileo-Hedge-Financial-Risk-Wind.pdf


http://www.wrma.org/pdf/Medienmitteilung%20-%20CelsiusPro%20and%20AGA%20Collaboration_EN.pdf

http://www.wrma.org/pdf/Medienmitteilung%20-%20CelsiusPro%20and%20AGA%20Collaboration_EN.pdf



Web sites:• http://www.wrma.org/ • http://www.cmegroup.com/trading/weather/• http://www.eurexchange.com/trading/products/WED_en.html• www.guaranteedweather.com• https://www.climetrix.com/• http://www.weatherderivs.com/• http://www.weather-risk.com/• http://www.climate.com/• http://www.galileoweather.com/• http://weatherdata.com/• http://www.willis.com/client_solutions/services/weather_risk/• http://www.wxrisk.com/


http://www.wrma.org/

http://www.cmegroup.com/trading/weather/

http://www.cmegroup.com/trading/weather/

http://www.eurexchange.com/trading/products/WED_en.html

http://www.guaranteedweather.com/

https://www.climetrix.com/

http://www.weatherderivs.com/

http://www.weather-risk.com/

http://www.weatherbill.com/

http://www.weatherbill.com/

http://www.galileoweather.com/

http://weatherdata.com/

http://www.willis.com/client_solutions/services/weather_risk/

http://www.wxrisk.com/

Introduction to Weather Derivatives By Anjelina Belakovskaia Weather Derivatives Trader Head of the Weather Desk at Williams Co. Copyright 2002 © Anjelina.

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